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U.S. budget battles shake faith in reserve currency

The U.S. dollar has been the global reserve currency of choice since the end of World War II, replacing the British pound sterling after 1944.

But the rounds of political wrangling in Washington, D.C., raised questions this week about the wisdom of holding so much U.S.-denominated debt when U.S. lawmakers can’t agree on whether they’ll repay it on time.

The U.S. Senate struck an eleventh-hour deal Wednesday that would avert a debt default, but the proposed agreement postponed, rather than resolved, the budget issues that sparked the crisis in the first place, setting up another potential round of high-stakes bickering next year.

Canada, with its stable and growing economy along with rising global demand for its resources, has been one of the beneficiaries of these concerns.

The Canadian dollar is now the world’s fifth largest reserve currency, the International Monetary Fund said after it began tracking the loonie for the first time earlier this year.

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And while the Canadian dollar has just a 2 per cent share of the massive $11.1 trillion (U.S.) market for world reserves, its growing status reflects the search for alternatives to the economic problems in the U.S. and Europe, the IMF said earlier this year.

It would take decades for the U.S. to lose its status as the de facto banker to the world, providing foreign coffers with U.S. cash that can be used to buy across borders, experts said.

“Erode is the right word. It’s not something that will happen overnight. But they’ll (foreign governments) be less willing to keep their reserves in U.S. dollars if they’re constantly under threat of the U.S. defaulting on its debt,” said Doug Porter, chief economist at BMO Capital Markets.

The Chinese government and a prominent global ratings agency both raised concerns about world reserves this week.

“It is perhaps a good time for the befuddled world to start considering building a de-Americanized world,” the official news agency, Xinhua, said in an editorial this week.

Given that China holds $1.3 trillion of U.S. debt, it’s little wonder the government has previously suggested moving to a “super-sovereign” reserve currency, one that would not be tied to a single country.

If America were to default on its debts or suffer a ratings downgrade, it would lower the value of all other countries’ U.S. reserves.

A prominent debt rating agency has warned the ongoing U.S. budget battles risk damaging investors’ faith in the currency.

“The prolonged negotiations over raising the debt ceiling (following the episode in August 2011) risks undermining confidence in the role of the U.S. dollar as the pre-eminent global reserve currency,” Fitch Ratings said in a note published Monday.

The previous high-stakes budget battle between the right-wing-dominated Republican Party in the House of Representatives and Democratic U.S. President Obama two years ago wreaked havoc on global markets before being settled. Fitch called the “repeated brinksmanship” in the U.S. damaging to the country’s image.

While the U.S. is still the reserve currency of choice, accounting for 62 per cent of all global reserves, it has been losing ground to the euro as well as the Canadian and Australian dollars, Scotia Capital Markets noted in a quarterly update on Oct. 1.

The euro is second at 24 per cent, while the rest is fragmented among other countries, Scotia Capital said citing IMF figures.

The Japanese yen and British pound are in third and fourth place respectively at about 4 per cent of total reserves.

Canada and Australia are in fifth and sixth place, accounting for about 2 per cent each.

Still, the U.S. remains the preferred reserve currency, said Camilla Sutton, currency strategist with Scotia Capital.

“If there was an alternative that offered the same type of depth and size of capital market, they probably would be eroding as the world currency,” she said. “But there really isn’t an alternative at this point.”

In fact, in times of economic uncertainty, demand for U.S. Treasury bonds rises, she said, even when the U.S. is the cause of the problem.

Canada’s share has “grown significantly” because it offers that rare combination of a highly developed bond market and a triple AAA credit rating, she said.

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